Most owners planning for retirement are dependent on the sale of their companies to provide the cash needed to finance the next phase of their lives. A substantial amount of their wealth is trapped inside the illiquid asset that is their business. And the fact is that a majority of owners will have to boost the value of their businesses before they transition them to new owners or they will not net enough money from the transition, after taxes and fees, to fund the rest of their lives.
After successfully growing their businesses for years, most owners think they will be able to sell for top dollar when the time comes. But, in reality, while growing their businesses, owners are making financial mistakes that can actually decrease the value of a business from the perspective of a buyer.
However, with proper time, planning, and guidance, there are ways these mistakes can be corrected to increase the value of the business. It’s especially important to take these factors into consideration if your plan is to sell your business to a third party – as historically, only one in five businesses that attempt to sell externally does so successfully. While many owners think that increasing the value of their businesses may take too much time – or worse, be impossible – it is key to a successful sale.
Mistake 1: Focusing on Tax Minimization
Many business owners operate their companies to minimize income taxes. However, this is not the best practice when it comes to maximizing business value. Minimizing taxes while preserving the true profitability of the company makes good business sense, but minimizing taxes by artificially lowering profits can cost you a staggering amount during the sales process. In an effort to pay the minimum amount of taxes, many owners run “lifestyle businesses.” By that we mean the owner seeks to take as much money as possible out of the business in order to fund the family lifestyle and keep his or her tax burden to a minimum. Unfortunately, this money is usually spent on an increasingly expensive lifestyle and is rarely saved for the owner’s future needs. This is actually just a form of consumption, rather than the creation of wealth, which would occur if the business were treated like an investment.
Mistake 2: Not Focusing on Margins
Of course, it is important to have increasing revenue. However, profit margin is often ignored in the process of increasing revenue, which can decrease the value of a business. Gross profit margin is the percentage of revenue you retain after accounting for costs of goods sold. Companies that sacrifice their margins in order to keep gross revenues high reduce their overall profitability and company value, and they weaken their position in the marketplace.
One key strategy for increasing margins is to add recurring revenue to your business, such as:
- Service or maintenance agreements
- Consumable product or replacement part contracts
- Subscriptions for products, services, or information
Recurring revenue is guaranteed revenue, at least for some time, which does not require the same level of sales and owner effort as one-time revenue. This revenue often has much higher margins and is always coveted by buyers. Studies show that businesses with recurring revenue sell at much higher multiples than those that don’t.
Mistake 3: Not Making the Tough Decisions
Without question, tough economic times call for tough decisions and lean business practices. One of the biggest mistakes business owners make is not trimming staff quickly enough when the sales pipeline dries up. This can sometimes be due to their allegiance to loyal employees who may be like family. If not addressed quickly enough, this mistake could ultimately cost everyone their job and the owner their business. Tough times often require uncomfortable and unpopular decisions. If profits are down, owners must act quickly to cut expenses and undertake an honest assessment of their business market share, marketing plan, and overall strategy.
Steps You Can Take to Maximize Value
Owners must be vigilant about keeping their businesses competitive and growing in order to maximize value and ensure their largest asset is protected. We advise all owners to perform a detailed review of their businesses well in advance of considering any type of transaction. This exercise will uncover items that need to be addressed and/or corrected long before an internal or external buyer’s scrutiny or due diligence begins. Look for and shore up weaknesses, such as missing corporate meeting minutes, customer bad debts, undocumented policies and procedures, the lack of written job descriptions, insufficient employee non-compete agreements, environmental issues, and so on.
In addition, you should make sure that financial records are prepared according to generally accepted accounting principles (GAAP) and consider engaging a CPA to conduct a financial audit, especially if you are planning to sell to a private equity group or public company. Having three years of audited financials can position you in a very positive way and drive your selling price higher.
If you have been treating your business as a lifestyle and some of your value drivers are not up to par, it may take years to sufficiently correct these factors and maximize your business value. With ample time and good advice, most businesses can greatly improve their opportunities for selling and the value they will receive. We strongly recommend that owners seek comprehensive, holistic advice in preparation for any sale – whether internal or external.There is no substitute. This is most likely a once-in-a-lifetime transaction, and you cannot afford to make a costly mistake.